Detroit Bankruptcy: Key Points for Muni Bond Investors

By Rob Williams, Director of Income Planning, Schwab Center for Financial Research

After a plan to restructure the debt of the City of Detroit was rejected by city creditors in June, Emergency Manager Kevyn Orr, a corporate bankruptcy attorney appointed by Michigan Governor Rick Snyder to run the city, recommended a bankruptcy filing. The city filed for bankruptcy on July 18, 2013, making it the largest municipal bankruptcy since the Chapter 9 bankruptcy law was created after the Great Depression.

Because municipal bankruptcies are rare, there's little precedent to say what might happen to bondholders or other creditors, including city pensioners, current employees, city general obligation (GO) bond and city revenue bondholders. During the bankruptcy process, the value and payments to different classes of bondholders may be reduced, though the treatment of different creditors and debt types will be negotiated and, ultimately, subject to the approval of the federal bankruptcy court.

Muni market participants will be watching how the different types of debt are treated in the bankruptcy process to see if Detroit's case has broader implications for the security of bonds issued by other municipalities in the state of Michigan and in the broader municipal market.

We think that the protections for tax-secured GO bonds and essential service revenue bonds will remain strong nationwide, with some variation by state and situation. We also believe that bankruptcy is a last resort for Detroit, a city facing a decade or more of financial and economic decline, and not a sign that we will see a significant increase in municipal bankruptcy filings.

City of Detroit GO bonds. The city emergency manager's restructuring plan proposes that payments on secured debt, including city GO bonds, be reduced. Generally, tax-secured GO bonds have been considered to be the strongest, most secure pledge of a state, city, or other municipal government. When they were issued, Detroit agreed to levy additional taxes to help pay the GO debt. It's not clear whether the court will allow this treatment of GO bonds and bondholders. Generally, we still favor GO and essential service municipal revenue debt because of these credit protections.

City of Detroit revenue bonds. Detroit bonds secured by city enterprise revenues, such as the city's water system, have been excluded from the city manager's recovery plan, at least as proposed currently. The plan proposes to pay these obligations in full, without involvement in the bankruptcy case, because they are secured by special, dedicated revenues from enterprises that are not part of the city's general operations.

Other Implications for Bondholders

Bond insurance. For outstanding bonds covered by bond insurance, the insurance companies may continue to pay principal and interest in full during the negotiations and possibly throughout the bankruptcy process. If the bankruptcy process results in a restructuring or reduction of debt obligations, it's possible that bondholders could face a reduction in interest and principal payments.

Muni markets. The municipal market is sensitive, at times, to headline risk—that is, the risk that high-profile news stories will cause increased volatility due to bond and bond fund selloffs. In periods where there is sentiment-based selling, the mark-to-market values can be driven down for the rest of the $3.7 trillion muni market. It's our opinion that we may see some volatility as a result of the Detroit bankruptcy, but we expect that it will be short-lived and limited. For investors with money to invest, such volatility caused by headline events may create buying opportunities.

Next Steps for Detroit

After the official bankruptcy filing is submitted to the court, there will be a 30- to 90-day process in which the court will determine whether the city is eligible for protection under Chapter 9 bankruptcy. To qualify a municipality generally needs to demonstrate that it has taken other steps to resolve and pay financial obligations.

Many states do not allow municipalities to file for bankruptcy at all, or they have stringent requirements, including state oversight, to help resolve financial troubles through other means. Detroit, over a series of years, had already explored those options, and the State of Michigan allows municipalities to file for bankruptcy, subject to certain conditions. The map shows the treatment of municipal bankruptcy by state, according to legal experts.

States Allowing Municipal Bankruptcy

To emerge from Chapter 9 bankruptcy, the City of Detroit must file a recovery plan that shows it can continue to meet its obligations to Detroit residents, balanced with payments due to bondholders, employees, contributions to the pension system, and other obligations. This could take many months to several years and will almost certainly be a difficult, aggressively contested, and expensive process.

Takeaway

Though the most troubled U.S. cities, such as Detroit, may continue to struggle to reduce spending, cover their debts, and manage in a slowly recovering economy, we do not believe that we will see a significant increase in municipal bankruptcies. The bulk of issuers with higher credit ratings and stronger credit characteristics have remained resilient.

Next Steps

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Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed income investments are subject to various other risks, including changes in credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications, and other factors.

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness, or reliability cannot be guaranteed.

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.